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The Return Of Restructuring?

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The world is awash in investor cash seeking returns, so why are so many companies restructuring rather than refinancing?

July 17, 2018
Author:
William Freedman

Recent headlines suggest that 2018 is shaping up to be a lively year for restructuring. BT Group in the UK, CA Technologies and Gibson Guitars in the US, and Toshiba and Hyundai in Asia are among the hundreds of public companies that have put plans in effect to reinforce their balance sheets and chase creditors from the door.

One troubling sign is that filings of Chapter 11 bankruptcies by financial-services firms in the US are on the rise. In 2015, they accounted for a meager $1.9 billion in liabilities; but in 2016, they totaled $22.1 billion—second only to the energy sector—according to a February report from PwC.

According to data—and, indeed, to the views of restructuring experts interviewed for this article—2018 is likely to be little varied from 2017 in terms of global volume. And yet, when asked separately where the world is in the restructuring cycle, everyone interviewed for this article cited the 2006-2007 time frame—right before the financial crisis that triggered the Great Recession.

What is notable about the current restructuring trend is its geographic and industrial breadth: It is spreading across oceans and continents, and while some sectors are harder hit than others, it seems no business is immune. Running out of cash isn’t just for oil drillers and retailers anymore.

So why are so many companies struggling to meet their debt obligations? Could the answer be corporate mismanagement? Are we out of externalities to blame?

Certainly mismanagement was central in several specific cases. Dubai-based Abraaj Holdings, now under restructuring, faces multiple legal battles over alleged misuse of funds. Fletcher Building of New Zealand is restructuring Australian operations and reportedly blames mismanagement rather than structural issues. Malaysia Airlines has been accused of poor management and an excess of political appointees by its union, while its forner CEO critiques a massive dismissal of engineers and loss of purpose.

Yet private equity seems to have a recurring if not central role in many of these cases, including the recent high-profile implosion of Toys R Us. A $3.75 billion cov-lite leveraged loan for Asurion, a US firm that insures wireless phones, is being used to pay an enormous dividend to its private equity owners—even as it pushes its debt over $11 billion and its debt-to-EBITDA ratio up to seven.

Irwin Gold, California-based executive chairman of Houlihan Lokey, a global investment bank with a highly ranked financial-restructuring practice, says that restructurings are generally triggered by cyclical situations, such as the boom-and-bust rhythms of the oil industry; or by secular conditions, such as the decline of retailing in the face of e-commerce.

Those aren’t the forces at play for BT, a telecom and content provider; or for Hyundai, a carmaker; or for Toshiba, a diversified holding company. Setting aside the colossal example of GE, now splitting off units and exiting sectors, manufacturing conglomerates do not appear to be short on cash. Yet global brands are teetering—and not just smaller, less-capitalized ones. Distress is going up the food chain.

Low interest-rate policies were taken up to stimulate economies in the wake of the financial crisis. At the same time, trends left investors flush with cash and seeking returns. Corporate borrowers found it relatively easy to take on debt under favorable terms. Many companies have taken on debt rather than tap cash reserves.

Total credit to nonfinancial corporations is at its highest level relative to US GDP since the 2008 financial crisis—now estimated to be more than 70% of the US GDP, according to Skadden Arps’ corporate restructuring practice. The US-based Securities Industry and Financial Markets Association reports another $20 trillion more in long-term issuance every year.

It’s not just the US. The value of the global bond market, according to the BIS, is rapidly nearing $100 trillion. Around 80% of the $100 billion in Chinese corporate notes outstanding have a “keepwell agreement,” by which a parent company acts as guarantor for a subsidiary. Keepwells, which took off five years ago, were meant to bolster foreign investor confidence in Chinese bonds.

Since 2016, however, some of these “gentlemen’s agreements” have been breached. In May, CEFC Shanghai International Group defaulted on a $327 million bond underwritten by China Development Bank, while China Energy Reserve & Chemicals Group defaulted on a $350 million bond underwritten by Barclays. Both companies are continuing operations and selling off assets. Bondholders are only now finding out just what these agreements are worth in practice.

Adaptations like keepwells that warp the market aren’t limited to China. “Total leverage, at 5.0x, has not yet regained the 2007 peak of 6.0x, but deals are increasingly being struck based on ever-more-creative measures of pro forma EBITDA,” according to PwC’s restructuring advisory practice in the UK. That creativity is rooted in so-called “covenant-lite,” or “cov-lite,” lending, which means that terms are light on restrictions related to performance, cash flow or collateral. Private equity firms have embraced cov-lite borrowing to finance acquisitions, such as Hellman & Friedman’s $265 million in cov-lite loans to buy SnapAV or Gridiron Capital’s $205 million to buy Rough Country, a maker of off-road accessories.

“After three years of record issuance, cov-lite loans now account for the largest share ever of the US leveraged loan market, while at the same time debt cushions below first-lien cov-lite loans have fallen dramatically,” said Moody’s analyst Julia Chursin. “This deterioration portends lower investor recoveries in the next default cycle.” In 2007 17% of loans were cov-lite. Now it’s as much as 80%. The parallels to easy mortgage terms leading up to the financial crisis are obvious. “There’s cash sloshing everywhere,” says Tony Heaver-Wren, a partner specializing in liquidation and restructuring at Appleby Global law firm. “Banks and credit funds are getting far less discerning.”

Skadden Arps, PwC and other observers warn that a slowing of the economy, dramatic rise in interest rates or tightening of credit markets could increase corporate debt restructurings. That’s going to cloud the prospects for highly leveraged companies, which will need not just smart but brilliant management to weather any coming interest-rate or regulatory storms.

“There are businesses that just aren’t managed well and hit the rocky shoals,” Houlihan’s Gold says. “Capital will always come up short if the story doesn’t hold up,” adds his Australian colleague, managing director Jim McKnight. “That goes for the company, industry or manager.”